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Thursday, February 3, 2011

Should Index Investors use ETFs or Mutual Funds?

The consensus among index investing experts is that index investors with small portfolios should invest in mutual funds such as TD’s e-series and those with larger portfolios should invest in index ETFs. The idea is to minimize portfolio costs. However, the best choice depends greatly on how you trade in your portfolio.

Mutual funds tend to have higher MERs than ETFs do, but buying and selling ETFs has the costs of commissions and spreads. Once the investor’s portfolio becomes large enough, the MER savings with ETFs overcome the trading costs. But we can’t determine the portfolio size where ETFs become superior without knowing the investor’s trading habits.

To illustrate what I mean we’ll consider two hypothetical beginner investors: Jack and Jill. Each investor has chosen a portfolio mix of domestic stocks, foreign stocks, and bonds with target percentages for each. Jack chose to invest in mutual funds and Jill chose ETFs.

Jack likes to stay very close to his target percentages. He takes his monthly savings and divides it up across his mutual funds according to his chosen percentages. If one asset class has made a big jump in price he might even remove some money from it and put the money into a fund that is below its target percentage. If Jack had chosen ETFs instead of mutual funds, he would have to pay for 5 or 6 trades every month. With the cost of commissions and spreads, this might add up to a drag of $1000 per year on his portfolio. He is clearly better off in mutual funds until his portfolio becomes quite large.

Jill is much less active than Jack is. Jill just lets her savings build up as cash until it reaches at least $3000. Then she buys whichever ETF in her portfolio is below its target percentage by the widest margin. While her portfolio is small this might cause the ETF she buys to overshoot its target percentage by a wide margin, but Jill isn’t concerned. She knows that the percentages aren’t critical while her portfolio is small. Her percentages will fall more closely into line as her portfolio grows.

From these examples we see that trading style matters quite a bit in choosing between ETFs and mutual funds. We also see that it is possible for beginners to choose ETFs if they are flexible about asset allocation percentages in their early investing years.

7 comments:

As far as I'm aware, many mutual funds would have a problem with trading shares several times in a month. It's certainly the case with TD e-series, where you'll get dinged with a charge if you redeem any units within 3 months of buying.

@Anonymous: For my hypothetical investor Jack, the vast majority of these "trades" would be just adding new money to each of 4 or 5 funds with the goal of maintaining his asset allocation percentages. On rare occasions if one of the funds went on a tear he might not add any money for a few months and might even want to shift some of the money from this high-flying fund to another fund. I have no direct experience with the e-series funds, but my understanding was that Jack could do this without penalties. Certainly a more hyper-active trader who is making bets would run into penalties.

I am puzzled. I had mutual funds, recommended by my ex-financial advisor - 2.3% MER and it had hefty front/backloads. An ETF is 0.7-0.8% and the commisions, i.e. on Questrade is 4.95$. Indeed, there are few, very few mutual funds in Canada - such as PH&N - no-load, low MER (0.9%) that can be purchased at 9.95$ per transaction. How many transactions should the ETF investor do per year to match, let's say 4% of 50,000$?! Again, if one would want to shift the focus on ETFs, would the same one shift the focus on mutual funds as well?! The problem that I noticed with ETFs is not the one with commissions but rather that some are so obscure that, although placed in good areas - such as high-yield bonds, due to low level of interest, they do not see much profit. Also mutual funds, have dividends which get reinvested, rolling the snowball. But, in the end, practical examples of particular situations could make it a simple math - who they are trading with, how much, investing term and area, is there a low-cost, no-load mutual fund available.

@Andi: I was comparing the broad index ETFs that have MERs typically below 0.25% to the TD e-series index mutual funds where the MERs are more like 0.5%. There are definitely more expensive and obscure ETFs and mutual funds.

Very interesting.... I've been building up my portfolio directly through ETFs, trying to aim for a proper asset allocation in 2012 or 2013... I'm clearly more in the Jill category, but I can say the real danger is more in getting tempted to go stock picking or trying for market timing, given that my asset allocation is out of whack, to begin with.

@Paul: It can be very difficult to resist the temptation to act on hunches (or fail to act out of fear). All scenarios where an investor maintains an asset allocation involve buying stocks when almost everyone is sure that buying stocks is a bad idea.

Sorry, Michael for not paying more attention - yes, in this particular scenario commissions and fees are important. @Paul - I think balancing the portfolio, asset allocation is overrated (I hear the angry shouts!). A perfectly balanced portfolio would probably generate near to nothing profit: yin and yang do even out each other! To have emerging markets win, industrial production in developed countries has to fall etc. Also, timing the markets is a thought which, while human, can bring a lot of bitterness. I made 33 per cent profit on an investment, sell it and then crying over the remaning 5% that I could have done should I have kept it - until I realized I was being stupid :). Michael focuses - with good reasons - on human aspect quite often as the market is dominated by our emotions as much as by economic realities (lately even more :).